50% Correction Looming

August 27, 2014

The stock market run we've had has been best described as resilient. With increasing conflict in Iraq, Russia and Ukraine, constant struggles between Israelis and Palestinians, higher interest rates looming and a stagnant European economy (with Germany and France, some of Europe's stronger economies, showing weakness) one would definitely expect the stock market to be either steadily declining or at best trading sideways.

Of course, this simply isn't the case, as the stock market hasn't even experienced a 10% correction since the 2008 crash. It just seems as though the market participants are completely ignoing any bad news but are incredibly bullish on any piece of good news. Our Shiller P/E is at the exact same ratio as it was before the 2008 crash. I would rather track free cash flow per share as a better indicator of a company's perfomance and health, but Wall Street trades on P/E and when there is any increase in the ratio, regardless of real performance indicated by FCF, Wall Street inflates prices by buying more. The markets are overvalued, while no one wants to look at the information that could cause it to decline back to fair value.

The Fed has been the main catalyst to this "growth" by keeping interest rates low, which forces many investors to pour their money into the stock market in order to achieve decent returns on their money. In addition to this, credit is still pretty tight, which makes it difficult for people to create businesses to build wealth so they must once again turn to the market for wealth creation. QE3 will be ending soon, and interest rates may be raised in summer 2015.

Now I don't think we are set to decline 50-60%, but when the correction does happen, the same investors who ignored all the signs of a decline will be the same ones looking at any information as proof that the economy will crash. Investor sentiment is on a pendulum, and it appears it has hit its peak of bullish ideas and is set to turn bearish. When the correction does finally happen, it won't be for 10%, but it will present the best buying opportunity for value investors.

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